Financial Risks, Stability, and Globalization
Chapter

17 The Changing Role of the IMF and the World Bank in Assessing and Promoting Financial System Soundness

Author(s):
Omotunde Johnson
Published Date:
April 2002
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Author(s)
CARL-JOHAN LINDGREN

Let me start with some history on the IMF’s changing role in promoting financial system soundness, especially as there have been a number of activities related to financial system soundness that have been converging in the last few years. As you may all know, IMF has been involved in financial sector strengthening for a very long time. It started off as technical assistance in central banking by the so-called Central Banking Service (CBS) in the early 1960s. In the early 1980s the CBS evolved into the Central Banking Department, which 10 years later became the Monetary and Exchange Affairs Department (MAE). It should be noted that MAE in its different incarnations, together with the Fund’s Legal Department, has assisted most of its member countries in putting in place central banking and banking legislation, and setting up monetary management and banking supervision structures and capabilities.

In the 1980s, the focus of the promotion of soundness was on developing instruments and frameworks for monetary management, as well as money and foreign exchange markets. This led us to look at the transmission mechanism for monetary policy, which in turn led to an analysis of the relationship between bank soundness and macroeconomic policy. It was clear that this was a very important relationship. In 1996, we brought a policy paper to our Executive Board, which made the then pathbreaking decision that banking system soundness in itself should be considered a major policy objective for macroeconomic stability. This triggered a search for ways in which to assess financial sector soundness operationally, and how to integrate such assessments into the broader economic and financial analysis done in the context of IMF’s Article IV consultations.

In parallel with these developments, starting in the late 1980s, the IMF was heavily involved in the reforms of the transition countries in Central and Eastern Europe. The IMF was given the task of coordinating the worldwide effort of assisting these countries to establish independent central banks and market-based financial systems. This effort, which was carried out by MAE, brought together experts from all over the world to provide technical assistance and transmit knowledge. This also led to a search for a consensus among experts from different backgrounds on what constituted good practices and policies in different areas of the financial system. The result was an increasing number of reports describing good practices and efforts to gain international consensus on good practices.

In mid-1996, you may recall that Mr. Michel Camdessus, the IMF’s former Managing Director, suggested that the next major financial crisis would originate in the banking system and urged the international financial community to develop international banking guidelines applicable to all countries. At that time, he also suggested that the Fund would be prepared to put together such guidelines—and the IMF staff was instructed accordingly. Not surprisingly, this created some friction with banking supervisors worldwide, and especially with the Basel Committee, which felt that it was responsible for developing such standards—and rightly so. This led the Basel Committee to form an international outreach group that developed the Basel Core Principles (BCPs). We in the IMF have been strong supporters of the work first to develop the BCPs and later to assist in their dissemination and implementation.

Two other areas of pathbreaking work in the mid-1990s were deposit insurance and systemic bank restructuring. On the former topic, we surveyed all the countries in the world in an attempt to figure out what constitute best practices. We have published these surveys and also have shared the results with member countries receiving IMF technical assistance. More recently, we have been pleased to see that the Financial Stability Forum has picked up the topic, first by setting up a study group and subsequently a full working group with the aim of developing good practices in this area.

On the topic of bank restructuring, of which deposit insurance is a part, the issues are more complex and far-reaching. Here our focus was both on practices to deal with problems in individual problem institutions, and on broad systemic issues and outright systemic crisis.

This work began with research of some well-known problem cases and later focused on the problems of the transition countries, but soon it was clear that our findings had universal applicability. In early 1997, we brought a policy paper on Systemic Bank Restructuring to our Board. This paper was the result of a long process of bringing people from all over the world to Washington to share their actual operational experiences from systemic crises. Needless to say, this background work served us extremely well when we had to deal with the real thing on an unprecedented scale in Asia in the middle of 1997.

The main lesson of the Asian crises is that the financial sector does matter very much for macroeconomic performance, especially in cases of highly leveraged systems. If we do not properly consider financial sector and macroeconomic weaknesses, macroeconomic management easily can become overwhelmed. So now, every IMF mission is reminded to look into the financial sector and to explore its two-way linkages with the macroeconomy. This is a major change from where we were only a few years ago. It is often said that the IMF should have focused on the financial sector a long time ago—maybe so, but what is important is that a very major change has been brought about in a very short time.

Financial sector analysis has mainly focused on the core banking sector. But it also needs to extend to any other areas of financial intermediation that has systemic implications, such as the payment system, debt, and insurance markets. Whenever relevant, this analysis is brought into overall assessment of a country’s financial system, which in turn is matched with the macro analysis in the context of Article IV consultations. Many of the different activities to promote financial sector soundness are thus converging, and increasingly so under the framework of the Bank-Fund Financial Sector Assessment Program (FSAP), which is discussed in Chapter 18.

Standards assessments are a part of the FSAP, but we were just told by Mr. Icard that he had identified 64 different standards. To assess all those standards would be an enormously labor-intensive task, not only for the IMF and the World Bank but also for the countries subject to such assessments. One therefore has to be very selective. We have solved this by delegating the task of prioritizing work on standards and codes to the mission team leaders under the FSAP. Their instruction is to cover only those areas that are truly important and relevant for identifying financial sector vulnerabilities and development needs. Criteria for setting priorities should be whether or not compliance with standards matter in terms of macro vulnerabilities, and whether their assessment will help in identifying major inefficiencies and reform needs.

In addition, when assessing countries’ compliance with various standards and codes, for example, with the Basel Core Principles, it is very important to consider the institutional and macroeconomic context. If the preconditions are not taken into account, assessments would be made with a “tunnel vision,” which means that the conclusions based on a narrow assessment could be misleading and quite different from those taking into account the broader legal and institutional framework. We have attempted to achieve this by seeking to do standards assessments within the FSAP framework and then bringing the overall assessment of financial sector vulnerability and development needs into the Article IV consultation framework, where the macro aspects are fully taken into account. This way standards assessments will be an important tool for the overall assessment, but will not be allowed to degenerate into a detailed assessment of every last standard.

One of the main purposes of standards assessments is to identify weaknesses and gaps. But I fully agree with Mr. Icard that the other main purpose is to bring about corrective action and to identify the best ways of reform, including the priorities and sequencing of reforms. To achieve actual reforms, the assessments could identify specific actions by the authorities and, to the extent outside help is needed, how external assistance can best be provided, and by whom. The IMF, World Bank, and other national and international agencies stand ready to support such reforms. This said, it should be noted that the assessment process is an ongoing process to help countries help themselves and, by doing that, to help strengthen the international financial system.

Some ask whether the Fund and the Bank should be in the business of setting and assessing standards and good practices. I fully agree with the point that the Fund should not be in the standard-setting business, even though we have developed some of the transparency and data standards. On occasion, we may have to develop best practices to guide policies, especially in areas where no clearly established standard-setter exists. But in all cases we need to be consulted, because we have a lot of experience from our country work that we can bring into the standard-setting process, and we can provide feedback once standards are being assessed and implemented.

When it comes to assessments of standards, the international standard-setting bodies generally welcome the involvement of our two institutions, which they consider the only ones that have the reach to cover all countries. Accordingly, we are working very closely with standard-setting bodies like the Basel Committee on Banking Supervision, the International Organization of Securities Commissions (IOSCO) in securities, the International Association of Insurance Supervisors (IAIS) in insurance, and the Committee on Payment and Settlement System (CPSS) in the payment system area. We have become a de facto implementing arm of some of these bodies, because we disseminate their principles, help countries implement them, and give feedback to the standard-setting bodies on our findings.1

One early finding was the need for a standardized methodology for each type of assessment. For the BCPs, such a methodology was developed as a joint project between Basel Committee members and Bank and Fund staff. This meant that the 25 core principles were converted into 227 different essential and additional criteria to be assessed. This has given more depth and uniformity to the BCP assessments and made them comparable across countries. The use of uniform and detailed methodologies for assessments has also made self-assessments more objective and credible. The type of methodology developed on the banking side is now being repeated in the areas of securities, insurance, payment systems, etc., with Fund and Bank involvement. These are very positive developments.

Another area where major work is under way in the IMF is on the development of macro prudential indicators that would forewarn national authorities and the international community when things begin to go wrong and further work and attention is required. In cooperation with similar efforts in many countries, we hope to be able to report major progress relatively soon. To use bank supervisor vocabulary, using macro prudential indicators is like off-site monitoring on a macro level, while IMF missions are more like an on-site presence.

Problem detection and crisis prevention are, of course, two of the objectives of this whole exercise. By identifying and bringing problems to light much earlier, the severity of crisis could be reduced. This may include pointing out internal governance problems and how they could be corrected. Often we see that on the technical level things are known and the appropriate corrective efforts may be under way, but they are often overruled by political considerations and often concealed from the public view. So the more we can make problems transparent early, the better the chances that corrective measures will be taken and a crisis avoided. By waiting too long, of course, sudden transparency may trigger a crisis.

Let me mention a few words about the cooperation between the Fund and the Bank. There have been headlines indicating all sorts of problems, but they are vastly exaggerated. Two years ago, a Bank-Fund Financial Sector Liaison Committee was created. It meets every two weeks, or more often if needed, and we have found coordination to be very good on the whole. In practice, the cooperation takes place very much at the micro level between mission chiefs and mission teams. There are always personal frictions and problems, but basically things have been working out very well, and I think that both sides see this as very positive.

Attitudes toward cooperation are beginning to change. Everybody knows that the world demands that the two institutions work closely together. This is not only to join forces and save on resources, but also to develop better and more consistent policy advice for the benefit of our member countries. This is actually happening, largely under the umbrella of the FSAP. This notwithstanding, the Bank and the IMF are still very separate and very different institutions, and there is a certain constructive tension between the two. But there is also a division of labor, with the IMF looking more at the immediate macro and vulnerability aspects and the Bank looking more at development and long-term capacity building.

In addition, the IMF and the World Bank are actively cooperating with relevant national and other international institutions. We clearly cannot do all assessments and financial sector work alone. Therefore, we have a major operation under way to bring in experts from national authorities and international standard-setting bodies. This is a good way for us not only to bring in additional resources to complement our own manpower, but also to bring in the kind of top-notch industry expertise that we need to carry out assessments. Also, if you bring in the best people from around the world, the assessments carry much more weight all around—in the receiving countries, in the international financial community, and in our own Executive Board.

In many areas there is no standard setter, best practices are far from obvious, or the issues are complex and fall in between the areas of competence of existing standard setters. Here the creation of the Financial Stability Forum (FSF) is very good news, because the FSF has the type of overarching authority to deal with issues that otherwise are “falling between the cracks” in the existing international institutional setup.

Among such issues, let me mention one that I personally think is a major development in the promotion of financial sector soundness: bank supervisors and accountants finally are getting together to develop common loan classification and loan valuation criteria. Of all the weaknesses in the financial sector, it is my view that the difficulties of valuing loans is the “Achilles’ heel.” If loan valuation is not right, capital adequacy is not right, and the key numbers for banking sector analysis are wrong.

Let me conclude by saying that the FSAP is providing us with a new framework for bringing the assessments of compliance with financial sector standards into broader financial sector vulnerability assessments and subsequently into the IMF’s overall economic assessment of countries’ economic and financial situation in the Article IV consultation process. This is always done in consultation with member countries, and the countries will always be given the opportunity to give us feedback and explanations. It is absolutely essential that there is full national ownership of specific financial sector reforms. Such reforms are microeconomic in nature, and often so numerous and complex that they are not likely to happen without a very clear national understanding.

One of our main challenges is how to develop new techniques and indicators for spotting emerging financial sector problems early. Bank numbers are notoriously misleading when you need them the most, i.e., when banking systems head toward problems; so one will need to look through balance sheets at the real sector, which often gives ample warning signals. To do so will require more focus on the real sector than we have done in the past.

In sum, there is a lot of work that still needs to be done to promote financial sector soundness, reduce the probability for surprises, and deal with whatever problems that may occur. But I believe that we in the Fund and the Bank are well on our way to meeting the challenges.

IMF also has the mandate under Article IV to do surveillance of members’ financial sectors, including assessment of compliance with benchmarks in certain areas, where relevant.

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